Behind the Numbers: Active share is not the only answer

The ongoing issue of closet tracker fund managers has rankled investors for some time.

The typical 0.75 per cent charges on active funds compound the issue and investors are keen to weed out these managers.

An academic study into this problem was first conducted by Martijn Cremers and Antti Petajisto of the Yale School of Management in 2006, when they coined the term Active Share. The statistic conceptualises how different the stock holdings in a fund manager’s portfolio are from that of its benchmark index. The pair concluded from their study of 2,650 funds that those with the highest active share of 80 per cent or more beat their benchmark indices by 1.49 to 1.59 per cent net of fees over a period from 1980 to 2003. A fund with an active share of 100 per cent has a portfolio where its stock holdings are entirely different from that of the benchmark index, while a fund with an active share of zero will simply replicate that benchmark.

Since 2006, further studies have advocated the use of the active share statistic and have placed pressure on global regulatory bodies to challenge fund managers openly, in attempts to persuade them to reveal these publicly. Given that some fund managers already do publish their active share statistics, for the sake of consistency and transparency, by making their disclosure mandatory this could enable investors to identify genuinely active funds for their own benefit.

One fund group that makes its active share statistics publicly available is Baillie Gifford. Its Japanese fund has an active share of 81 per cent and is benchmarked against the Tokyo Stock Exchange (Topix) Capital index.

In the three years to August 2015, the fund has returned 58.36 per cent versus the Topix index return of 50.12 per cent, reflecting modest performance at best. For a better perspective it is worth noting that the Neptune Japan Opportunities fund is also indexed against the Topix, however that is about as far as the similarities between the two funds fund go.


FE Alpha Manager Chris Taylor at Neptune has a far more concentrated portfolio than his counterpart at Baillie Gifford, including just 40 to 60 stocks. The Neptune Japan Opportunities fund has returned 102.94 per cent over the three years to August 2015, yet its active share is identical to that of Baillie Gifford’s Japanese fund at 81 per cent. This result evidently shows that there must be other, more salient factors predicating the fund’s total return other than the active share.

Investors who focus too heavily on the active share of a fund’s portfolio are missing sight of the bigger picture, as they must consider the statistic’s inefficiency when used in isolation. By itself, the active share can mislead investors into thinking that it is only skillful fund managers who will have a high percentage of stock holdings different from the benchmark. This is not the case.

Take an unskilled fund manager whose portfolio barely resembles the benchmark index. A recent paper conducted by Eoin Murray, head of investment office at Hermes Investment Management, shows that significant underperformance of such funds occurs in the aforementioned settings. He advocates that other statistics should therefore be used in conjunction with the active share.

So while active share looks purely at the difference between the stock holdings of a fund’s portfolio and the prescribed benchmark, the tracking error meanwhile studies the divergence in returns of the fund from that same benchmark.

Funds which track a particular index such as the Topix will typically have a low tracking error, implying that the fund is doing a successful job of indexing itself against the benchmark. While the actively managed Neptune Japan Opportunities and Baillie Gifford Japanese funds both have the same active share of 81 per cent, despite having different risk profiles, how do their tracking errors stack up?

The tracking error for the Neptune Japan Opportunities fund is 12.15 per cent in the three years to August 2015, while over the same period the tracking error for the Baillie Gifford Japanese fund is only 5.64 per cent. Interpreting these figures, a higher tracking error indicates a more actively managed fund, as the Neptune Japan Opportunities fund has a greater proportion of returns which diverge from that of the Topix index.

Given what has already been said about the active share debate, it is perhaps not surprising that many investors are deciding to shun active funds in favour of low-cost passive trackers. Although active investments still dominate market share for investors’ money, it is passive investments that have recently dominated fund flows.

To highlight this, Morningstar reported earlier this year that passive US equity funds received inflows of $166bn (£106bn) in 2014 while active funds lost $98bn. The largest beneficiary of this trend has been Vanguard, who as the world’s biggest provider of passive investments obtained more net inflows in 2014 than any other manager – when compared to more than 3,000 groups in total. Part of this success stems from the unique costing structure in place at Vanguard, enabling the firm to keep its average expense ratio for its fund range at just 0.19 per cent in the US.

The rise of passive investing looks unlikely to abate anytime soon but the regulators must provide more clarity on the active share debate. If there is to be a drive to make active share disclosure mandatory then active fund managers must not be forced to behave in a way which would be counterproductive towards investor interests.

Take, for example, a period of market stress where it may be necessary to maintain a cash buffer to protect the portfolio from further falls. The active share would considerably suffer from such a move, so the desire to preserve a high rating may mislead the fund manager into acting negligently.

For this reason, the active share should not be viewed in isolation. When it is being used by an investor, it should only ever complement a decision to invest and should be used in tandem with other equally valuable measures, such as the tracking error.

Key takeaway:

Active share has increased in popularity in recent years, with more fund managers coming out to publish the figure for their funds. However, it cannot be considered in isolation and must be used alongside other information to weed out closet trackers.

Patrick Enright is a research assistant at FE.